| Christopher Acito, Gapstow Capital Partners |
Credit and debt hedge fund managers who feasted on bargain-priced structured securities after the financial crisis will face significant challenges in the coming year now that legacy issues have generally returned to more normal values, market participants say. Christopher Acito, chief executive and chief investment officer at billion-dollar, credit-focused fund-of-funds firm Gapstow Capital Partners, says hedge fund managers will need to dig for profits among newer issues or perhaps get into loan origination or structured product creation to make up for the dwindling opportunities in legacy debt and credit. In many cases, managers will need to ask their investors for longer lockups to accommodate investments that will probably take more time to produce desired profits, and those longer lockups in turn could prompt investors to ask for more generous terms, he says.
Acito sees major changes across the spectrum of structured credit, including residential and commercial mortgage backed securities (RMBS and CMBS), as well as collateralized loan obligations (CLO). Some of the biggest challenges revolve around legacy RMBS, which were among the assets dubbed “toxic” during the financial crisis but have since recovered.
“Can RMBS managers continue to survive as legacy mangers or do they need to become more active, not just buying and selling but originating loans and purchasing loans?” Acito said in a recent conference call. “That is not the same skill set. Many legacy managers won’t survive.”
Some legacy debt managers have already started talking about shifting into loan origination and security creation. At Pine River Capital Management, the $16 billion alternative asset manager based in Minnetonka, Minnesota, that is known for its MBS strategies, Brendan McAllister, partner and portfolio manager of the Pine River Fixed Income Fund, agrees that legacy opportunities are far less attractive these days. The next big play, he says, will likely be in less liquid investments, like making direct asset-backed loans, a business from which banks have retreated in response to financial reforms. Those loans could then be repackaged into structured securities for resale. He cited real estate lending and aircraft leasing as two areas where hedge funds like Pine River could maneuver. “These are markets that have been dominated by banks,” he says. “Private capital is becoming more important.”
Tom Williams, chief investment officer at Man Group’s FRM Pine Grove, another billion-dollar, credit-focused fund-of-funds firm, says that while the big payday may be over in legacy structured credit and debt, there is still money to be made for managers skilled enough to sift through deals. He cited the RMBS market, where the overall pool of non-agency legacy loans — those not backed by agencies like Freddie Mac or Fannie Mae — has shrunk as a result of defaults and refinancing. What remains are higher quality loans in legacy RMBS. Higher quality combined with lower supply should continue to push prices up, he says.
But investors in hedge funds who focus on legacy structured products like RMBS shouldn’t expect the double-digit returns of the past. Indeed, he says investors looking for high yields have already abandoned the sector.
“Those who were shooting for the moon pulled out a year ago,” Williams says. “People who are in it now should be happy with high-single-digit returns.”
One potential sweet spot for credit managers could be the energy sector, where plummeting oil prices could undercut the ability of energy companies to keep up with loan payments. But that area is seen as more appealing to distressed credit managers than those who deal in structured products. Indeed, several distressed managers are already circling. Distressed managers Marc Lasry at Avenue Capital Group and Jason Mudrick at Mudrick Capital Management both say they are actively monitoring the energy sector for potential distressed debt investments.
Brett Jefferson, founder and chief investment officer at opportunistic credit shop Hildene Capital Management, says he is wary of energy, which he views as a niche with assets like offshore oil rigs that demands specialized knowledge different from other types of assets. But Jefferson is also convinced that the times require credit managers to take a more creative approach to their strategies. He has entered the business of creating CLOs for other types of assets.
“We are in essence a finance company,” Jefferson says. “We look for good pieces of credit, then we securitize them.”
That is a much different style of investing than trading existing securitized debt and credit. But it may be the style more suited to the current environment for credit and debt.
